An Inflation Indicator To Watch, Part 3

In particular, I’m proposing a circular-flow inflation indicator that consists of bank-created money, the trade balance and real GDP growth. As described in the bullets above, bank-created money and the trade balance measure injections to and leaks from the circular flow—they tell us whether injections and leaks could be upsetting the balance between purchasing power and capacity—while real GDP growth approximates capacity. Using “M63” for bank-created money (see Part 1 for further explanation), the exact inflation indicator is M63 growth plus the trade balance as a percent of GDP minus real GDP growth.

History’s Pages

To be sure, this is a high-level indicator—it should help predict major trends, not month-to-month volatility. When I tested it against history, I wanted to see if it explains inflation’s big-picture behavior in each business cycle, and it does exactly that, as I’ll demonstrate by comparing the indicator to core inflation over the last eight cycles. Here’s the core inflation data:

The chart shows why it makes sense to evaluate each business cycle as a separate event—namely, business-cycle recessions normally act as reset buttons, crushing inflation by constricting pricing power, which then sets the stage for the next expansion. So inflation begins a new life with each expansion, and the chart shows the differences from one to the next. To keep it simple, I assigned each of the business cycles to one of three inflation categories (low, moderate and high), and I also noted whether inflation was rising or falling relative to the previous cycle.

My first test, then, is to track the paths followed by the circular-flow indicator during three cycles plagued by high inflation:

As you can see, the indicator went three for three, climbing higher during all three cycles. In circular-flow speak, there was too much purchasing power chasing too few goods. Anyone who had followed the indicator during those periods—basically, the 1960s and 1970s—would have expected the inflation dragon to fly free and been on the money.

But what about the five cycles marked by disinflation or low inflation?

Here are the indicator readings during those cycles:

Once again, the indicator had a perfect record—five for five in predicting the inflation dragon was caged and then being proven correct. In each period of disinflation or low inflation, purchasing power was either losing or at a stalemate in the tug-of-war with capacity, and that continues today, although the trend turned sideways during the last three years. The recent turn from downward to sideways doesn’t tarnish the indicator’s historical performance—which I would call stellar—but if it turns upward from here that would become a cause for concern.

Daniel Nevins, DFA is the author of "Economics for Independent Thinkers" and proprietor of nevinsresearch.com.

He has invested professionally for thirty years, including more than a decade at both J.P. Morgan and SEI Investments. Apart from his book, he is perhaps best known for his behavioral economics research, which was included in the curriculum for the Chartered Financial Analyst® program and earned him recognition as one of the founders of goals-based investing.

He has an economics degree from the Wharton School of Business and a degree from the University of Pennsylvania’s engineering school.